Banking and financial services are about to go through a paradigm shift that could be bigger and potentially more disruptive than the one that occurred when credit cards became widespread. The change is a transition in which networked online platforms will completely or mostly replace brick and mortar banks.

The ground work for this change has already been set by the replacement of paper money by electronic records for most transactions. Now every other kind of financial transaction, including lending, is about to move completely onto the cloud.
Many bankers already realize this; investors, including large numbers of banks, have pumped a vast amount of money into the online lending platform Prosper. Wired reported that Prosper just raised $165 million from a consortium of investors that included J.P. Morgan Asset Management, SunTrust Banks and the insurance company and credit union USAA.

Banks’ investment in Prosper is surprising because Prosper is a platform that arranges hard money cash loans for individuals. Most of the loans are underwritten by individual or institutional investors through Prosper’s platform. Prosper has issued more than $3 billion in loans since 2006, and its competitor, Lending Club (NYSE: LC), has issued $7.6 billion in loans.

Lending Club went public in December, and so did a similar hard money lender, OnDeck Capital (NYSE: ONDK), which specializes in business loans. Prosper, OnDeck and Lending Club are not traditional banks; instead, they are marketplaces that connect borrowers and lenders.

Prosper’s $600 Million Quarter

Business is very good at Prosper; its CEO, Aaron Vermut, told Wired that his organization facilitated $600 million in loans in the fourth quarter of 2014. Interestingly enough, much of that is coming from people that banks do not or will not serve.

So what is going on here? The best way to think of the situation is that the banking system in the U.S. is broken and not meeting the needs of a large portion of the population. The United States Postal Service estimated that around 68 million Americans are unserved or underserved by the banking industry, in a 2014 whitepaper.
Lenders like Prosper, Lending Club and OnDeck are taking advantage of this by serving those who cannot get financing through traditional banks. They meet one of the needs of such people, the ability to borrow money, which is often critical for survival and success in a capitalist economy.

Such lending might not be as risky as you might think; Prosper claims that it only has a three percent default rate on its loans. That’s actually lower than the charge off and delinquency rate for all kinds of loans at traditional banks, which was 4.35% in the fourth quarter of 2014, according to the U.S. Federal Reserve. Prosper’s loans are not as risky as residential mortgages; if you look at the Federal Reserve’s figures, the charge off and delinquency rate for mortgages in the fourth quarter was 6.63%.

PayPal’s Lending Revolution

A recent Securities and Exchange Commission (SEC) filing indicates that the agreement that created the independent PayPal authorizes the payment processors to work with any online marketplace. In a nutshell, that means PayPal will be able to work with Amazon.com (NASDAQ: AMZN), Apple Pay, Alibaba (NYSE: BABA) and (gasp) Google Wallet.

If it were to play its cards right, PayPal could transform itself into a massive cloud-based financial clearing house. Not only would it facilitate vast amount of payments but PayPal would also issue a large amount of online loans through programs such as PayPal Working capital.

Basically, PayPal is now a hard money lender that makes credit available to select business customers. The loans are dispersed through PayPal accounts and repaid automatically by taking a portion of the profits on the sales. A minimum payment is required every 90 days.

This means a businessperson does not have to repay the loan unless he or she actually has cash coming in. It allows for more flexibility than a traditional bank loan and competes directly with credit card companies. PayPal Working Capital is only program, PayPal also offers lines of credit to customers.

PayPal has created an effective alternative to a bank; if it could leverage that with an app like Venmo, it could make it possible for people to access credit anywhere. A person with a smartphone will be able to access all the money he or she needs anywhere.

Apps Could Create a Financial Revolution

That isn’t a disruptive technology; it is a total revolution in lending. It’s also only the tip of the iceberg; what happens if PayPal purchases a bank or a platform such as Prosper or Lending Club or both? PayPal could become a one-stop shopping place for all financial services.

Imagine an Apple Pay type app in which you could not only make payments but access lines of credit, take out a loan or even tap your home equity or business’s cash flow. Such a tool will make it easier for people to do business and access the business system—a boon to the poor, it will also be a nightmare for regulators.

If PayPal teams up with a company like Walmart Stores Inc. (NYSE: WMT) or Kroger (NYSE: KR), it could reach almost every American with such services. Both Walmart and Kroger are currently offering banking services. This raises another fascinating possibility—a major retailer like Kroger or Walmart might buy PayPal or enter into an agreement with it to offer financial services.

Nobody will need a bank because there will be an app on your phone that is faster and more flexible than the bank. Bankers could go the way of elevator operators and pit traders.

One has to wonder if government will allow this financial revolution or shut it down. Do governments want a situation in which anybody can bypass banks and access any kind of financial instrument by simply touching an app? We need to ask this question before the banking system as we know it disappears.

Disclosure: Your blogger owns shares of Kroger and eBay Inc. He also runs advertisements for Prosper on his blogs on a regular basis.